The Canadian Securities Administrators (CSA) may soon make a fateful decision: Whether to ban embedded fees. These are sales and trailing commissions paid by mutual fund companies to brokers and advisers that sell their funds, which is the alternative to investors paying the broker for guidance. Banning embedded fees risks limiting the availability of investment advice to middle-income Canadians. Beyond that, the decision raises a broader issue, the overarching need for balance in regulating our capital markets.

Banking and securities regulators and self-regulatory organizations have as their core responsibilities investor protection, financial stability and market integrity. They are also charged with ensuring the efficiency and competitiveness of Canada’s financial system.

The result of an emphasis on the first set of responsibilities over the second has been an inexorable increase in regulation. There are compelling reasons for additional rules, including the growing complexity and sophistication of markets, investment products and market participants and the consequent need for more protection and comprehensive disclosure. A few intermediaries and market participants will look for ways to skirt the rules. Financial crises and scandals raise public concerns as well as the political pressure for action.

At the same time, problematic forces tend to foster regulatory overkill. They include regulatory creep, bureaucratic overreach and an insistence on mind-numbing verbiage in disclosure documents. Other dubious factors are the overwrought cynicism about the motivation of brokers and issuers and an inclination to see retail investors as almost helpless, and so not responsible for any poor decisions made in their portfolio.

Political overreaction to high-profile examples of questionable behaviour by fund companies or advisers can cause the pendulum to swing too far, propelled by intrusive rules that would not have prevented the scandal that precipitated them. Yet the pendulum rarely swings back to policy equilibrium. A few large companies behaving badly can inflict long-term damage on many large and small companies behaving properly.

However well intentioned, excessive regulation inflates costs, undermines efficiency, impairs competitiveness and can have uneven, unintended and perverse results. We already have regulations to protect investors, such as the know-your-client and suitability rules. We also have laws that mandate adequate disclosure and address conflicts of interest.

But, as Pierre Lortie points out in a 2016 paper for the University of Calgary’s School of Public Policy, we pay far less attention to the supply of and demand for advice — how adding rules and regulations can change the willingness of financial institutions to provide services, like advice, and the willingness of investors to pay for them. Banning embedded fees to ensure that advisers face no financial conflict of interest, so as to protect financially unsophisticated retail clients, means clients will have to start paying upfront for advice. Many will instead forgo the advice entirely.

This is just one of many unintended consequences that could come from banning embedded fees. Others include a fall in savings and returns and, most critically, undermining the competitive structure of the securities industry, shrinking the weakening independent brokerage sector even further.

These issues have become increasingly important because fewer than 40 per cent of employees are enrolled in a registered pension plan and only one-quarter are in defined-benefit plans. As a result, most people have to make decisions about their savings that will profoundly affect their retirement.

Unfortunately, too many investors do not possess even a rudimentary knowledge of financial principles, including the relationship between risk and reward, the importance of diversification, and realistic expectations of return. Yet they might believe they know more than they do, leading to excessive risk-taking. Not surprisingly, evidence suggests investors do better with financial advice than on their own. The Ontario Securities Commission just published a staff notice on behavioural insights, highlighting how investors can make irrational decisions based on emotions and other psychological factors.

Still, we have to resist the temptation to try to protect everyone from everything that may pose a risk, regardless of the cost, the limits on freedom of choice and the unintended consequences. It is unrealistic to think we can achieve perfect safety through rule making; risk is inescapable, and so are occasional losses (if we include lost opportunity).

Canadian policy-makers should do what they can to help investors educate themselves, to protect them from abuse, to make sure the facts are objectively disclosed and to permit access to qualified advice. What policy-makers must rigorously avoid is creating an advice gap between the wealthy who will pay for advice and the smaller, less sophisticated investors who, more often, will not, hurting the very people who most need protection. That would also burden the retirement system and reduce liquidity in the markets.

The CSA has evidently made up its mind that the conflict between advice and sales is exacerbated by embedded commissions, so it may be ready to ban them. However, there are alternative approaches, including a best-interest or fiduciary standard for dealers. A lot is at stake in determining the right balance. We had better be careful.

Joe Oliver is the former minister of finance, former president of the Investment Dealers Association and former executive director of the Ontario Securities Commission.

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